In the previous post we learned about the importance of taking interconnections between market players while performing a risk assessment process. As mentioned, this fact is not unique to banking or trading platforms, as pointed out in the “Ecology for Bankers” paper by May et. al. In this paper, the authors have presented an interesting analogous situation, in the form of fisheries management. For the past half-century, investments in fisheries science have focused on management on a species-by-species basis (analogous to single-firm risk analysis). With collapses of some major fisheries, however, this approach had gave way to the view that such models may be fundamentally incomplete, and that the wider ecosystem and environmental context (by analogy, the full banking and market system) are required for informed decision-making. This, in fact, coincides with the broader understanding that emerges nowadays in many areas of applied science, acknowledging the need for a larger-system perspective.

In the words of the authors : “Thus, although the study of payment flows is of immediate interest to central bankers, it may miss an essential aspect of systemic risk, namely the ‘contagion dynamics’ of public perceptions and asset valuation associated with the interaction of balance-sheets (the mutual financial obligations and exposures that link companies). For example, how contagious are inflated valuations of Internet stocks? Are there hidden, mutually dependent risks associated with such high valuations? It could be useful to examine the dynamic network of balance-sheets, and if possible to quantify the interactive effects of valuations, credit policies, hedging and so on among financial institutions, especially investment banks. Such balance-sheet networks could be helpful in studying the effects of asset- pricing bubbles, credit crises and the poorly understood but potentially worrying effects of the current widespread use of derivatives (futures and options) and dynamic hedging by investment banks to manage risk on the fly.”

So, what can we say about the networks that govern interactions (and further yet – correlations) between financial institutes and bankers ? This was the question that May et. Al set to explore. For this, they have studied the connection between financial institutes and bankers in the U.S. For this, the researchers used the following data that was presented by Soramaki et. Al. in their paper “The Topology of Interbank Payment Flows“:

The Fedwire interbank payment network

(a) This ‘furball’ depiction takes in thousands of banks and tens of thousands of links representing US$1.2 trillion in daily transactions.

(b) The core of the network, with 66 banks accounting for 75% of the daily value of transfers, and with 25 of the banks being completely connected. Every participating bank, and every transaction, in the full network is known (akin to an ecologist knowing all species in an ecosystem, and all flows of energy and nutrients).

What can we learn from this data ? Do our immediate intuitive insights from looking at these charts correspond to the ones we obtain after a deeper analysis of the data ? we will try to answer these questions in the next two posts.